New Cracks in IRA Protection

The old rule: IRAs were exempt from creditor claims in bankruptcy. Now there’s an exception: IRA money left to your children will not be immune from their bankruptcy creditors, thanks to a recent U.S. Supreme Court decision.

But there is a way to deal with this and reset the protection.

This all deals with Inherited IRAs. When someone has died with money still in his or her IRA, what’s left is going to whoever’s named as the IRA beneficiary. Voilà: an Inherited IRA.

Let’s change direction for a moment. We know that distributions from IRAs are subject to income tax when they’re taken out of the IRA.

An exception to that rule: if the money and assets “roll over” to your spouse, who can delay the income tax.

But it’s not an exception when you leave it to your children (or grandchildren, or whomever). They’ll inherit it (“Yay,” they’d say) but it’s taxable income (“Boo!”).

Your children have had two choices to deal with that tax, but neither of them are great in light of the Supreme Court decision.

A child could say “Give me my share of the IRA. I’ll pay the income tax on it. I don’t care.”

Or a child could say “I’ll put my portion in an Inherited IRA account so it will continue to grow. I know I’ll pay income tax on what I take out – or on what I have to take out, but that’s based on how old I am, not how old my parent was.”

But here’s what the Supreme Court decision did: regardless of the child’s choice, if he or she ever goes into bankruptcy, those Inherited IRA proceeds – or whatever’s left of ‘em – can be divided up among the child’s creditors.

The scary point here: this could happen at any time in the future, after you’re gone. Today your adult child may not have a care in the world, and owes nothing. But down the road . . . who knows?

That brings us to the third – and probably best — way to handle an Inherited IRA: an “Inherited IRA Trust.”

You direct that any remaining-at-your-death IRA would not go to your adult child directly; instead, it goes to a Trustee – a friendly one — who holds it, invests it and distributes for that adult child over the child’s lifetime. The Trustee can even dip into the proceeds to give your child more than just the minimum.

The Trustee is not your child. So the trustee cannot be forced to just pay over the money.

For example, the Trust gives the Trustee something called “spendthrift” powers. It means that if a creditor is hovering above your adult child’s head like a buzzard, the Trustee does not have to pay anything out of the trust. Instead, the Trustee can take steps to preserve the money for your child.

So with that new decision, why do you want your children to be the contingent (i.e., after-your-spouse) IRA beneficiaries? Why assume they’ll never have creditor issues?

Better: make your contingent beneficiary this friend or relative who will serve as trustee over the Inherited IRA. And here, a bankruptcy creditor who emerges in the future does not grab the money.

Many people opt to let their children have their choice when the parents are gone and if there’s IRA money left over. The prevailing wisdom was, “Let the child decide whether or not to stretch the IRA proceeds out.” But in light of the Supreme Court’s decision, this offers no asset protection.

How long does this last? Where will your children be in the future? What financial problems might they have? Your crystal ball is as good as mine, probably better. But why take a chance that a child may have a creditor just salivating over the IRA money you left?

So if you’re not going to spend your entire IRA during your lifetime, be prudent and explore this “Inherited IRA Trust” idea.

A final note: IRS has very strict rules on what legal terms must be in an Inherited IRA Trust; it’s not something to create or download. To put it another way: “Don’t try this at home.”